Customer Profitability Segments

21st November 2020 1 By indiafreenotes

Customer Profitability Analysis is a tool from managerial accounting that shifts the focus from product line profitability to individual customer profitability. Activity Based Costing looks at the various cost drivers to accurately isolate costs and determine a product’s profitability. In contrast, Customer Profitability Analysis is a method of looking at the various activities and expenses incurred in servicing a particular customer. In other words, it focuses on analyzing profit per customer rather than profit per product.

Customer Profitability Analysis (in short CPA) is a management accounting and a credit underwriting method, allowing businesses and lenders to determine the profitability of each customer or segments of customers, by attributing profits and costs to each customer separately. CPA can be applied at the individual customer level (more time consuming, but providing a better understanding of business situation) or at the level of customer aggregates / groups (e.g. grouped by number of transactions, revenues, average transaction size, time since starting business with the customer, distribution channels, etc.).

CPA is a “retrospective” method, which means it analyses past events of different customers, in order to calculate customer profitability for each customer. Equally, research suggests that that credit score does not necessarily impact the lenders’ profitability.

Application of Customer Profitability Analysis

From the given example, the customer profitability of the Individual segment exceeds the SME segment. This insight then supports the company in its strategic decisions. It can shift its focus towards attracting and retaining more customers from the more profitable Individual segment. Alternatively, it can look for cost reduction approaches for its SME segment. Potentially, it can work to redesign its purchasing process in order to reduce the frequency of visits or orders. Otherwise, it can look to charge its customers for additional service visits to shift the weight of the cost from the company to the customer.

Objective

The main purpose of CPA is to provide to organization management with the understanding of each customer profitability. Grouping this information into customer profitability segments, allows the companies to take different, targeted actions and strategies against different profitability segments, having as a target increasing the company’s total profitability. Those companies that understand which customers are more profitable and which are not are “armed with valuable information needed to make successful managerial decision to improve overall organizational profitability”.

CPA allows businesses to take the following key strategic decisions:

  • Identify customers’ profiles
  • Differentiate customer service activities depending on customer profile (e.g. highly-profitable customers could receive more attention, to ensure high-level satisfaction and loyalty, in order to protect continued business relations);
  • Differentiate marketing strategy, depending on customer profile (e.g. implement more aggressive and expensive marketing strategies to high-spenders, while limiting the marketing costs against customers, who spend little and show few signs of spending more in the future);
  • Take actions, to maintain or increase customers profitability, including turning unprofitable customers into profitable ones (e.g. decreasing cost to serve, of looking for ways to increase revenue, up to ceasing business relations with unprofitable customers to cut the costs).

Revenue associated to the customer

Revenue differences across customers may differ due to various reasons, including:

  • Differences in price charged for a unit a product or service to different customers
  • Differences in volumes sold to different customers.
  • Differences in product or service specification delivered to different customers.
  • Other one-time events, such as bonus events, not directly related to a particular sale transaction.

CPA requires a company to associate all company’s revenue to different customers (sources of revenue), in order to find out revenue associated to each customer. Companies most typically have no trouble finding out the amount of revenue attributed to a particular customer; thus, article will not cover this aspect.

Costs associated to the customer

Customers differ in costs they generate by using company’s resources in a different way. These reasons may include:

  • Different amounts of marketing costs may be necessary to strike a deal with different customers
  • Differences in used distribution channels / logistics by different customers
  • Differences in customer service required by different customers
  • Differences in volume of products purchased (production of large volume of a product for a single order can be cheaper that production of the same amount, divided into many orders, requested by many customers)

Limitations / implementation barriers

Using CPA is associated with some difficulties & limitations:

  • Most importantly, CPA is a backward-looking tool, meaning it analyses past events, providing results, based on which companies are making their strategic choices. Past however may not always be the determinant of the future, and decisions made based on past events only, could be incorrect if market conditions, or business strategy change;
  • The cost of acquisition and customer service may be difficult to measure;
  • Performing ABC or other methods of attributing costs to customers, CPA calculations, outlining distinct strategies towards different groups of customers, communicating internally and implementing those strategies can be a large undertaking for an organization in terms of the resources used and the costs to complete the initiative, requiring specialized knowledge and appropriately developed accounting systems;
  • People often feel threatened by change, do not understand it, and are opposed to it within a company (e.g. Commission salespersons will try to protect customers even though they may not be profitable to the company).

Overcoming limitations

There are various strategies which could be used to minimize limitations / implementation barriers to introduce CPA, including the following ones:

  • Management needs to be sensitive to required change within the organization and be sure that employees are included in the decision and change processes. Management should seek to ensure employee buy-in, to minimize resistance towards change;
  • Management needs to properly set internal incentive model, e.g. rewarding salespeople on the basis of customer profitability, as opposed to revenue generated by the customer;
  • To minimize the limitation resulting from the fact, that CPA is a backwards-looking tool, a company could additionally consider implementation of Customer Lifetime Value (CLV). CLV is a forward-looking customer profitability estimator, taking CPA as a starting point for calculation. CLV could be used for forecasting of future customer profitability (based not only on historical events, but also proposed marketing strategy, trends in customer behavior, etc.).